Will The Fall In Corporate Earnings Lead Toward An Economic Recession?

NEW YORK, NY - MARCH 11: Traders work on the floor of the New York Stock Exchange (NYSE) on March 11, 2016, in New York City. (Spencer Platt/Getty Images)

Do you remember the good times of late 2011 to early 2014? Profits for companies in the S&P 500 just kept on rising and stocks rose along with them. The fun stopped after the second quarter of 2014 when profits rose 10 percent.

The growth rate first declined and then turned negative in the second quarter of 2015. Stocks eked out another small gain, but have essentially been flat since the second quarter of 2014.

Analysts now expect a 9.8 percent drop in corporate profits in the first quarter of 2016, the fourth consecutive quarters of declines and a near certain signal of a wholesale economic recession. The only time a so-called "earnings recession" did not lead to an economic recession was during the Asian financial crisis of 1998.

(Bloomberg)

"Despite risk assets enjoying a few weeks in the sun our failsafe recession indicator has stopped flashing amber and turned to red. Newly released U.S. whole economy profits data show a gut-wrenching slump. Whole economy profits never normally fall this deeply without a recession unfolding," writes Albert Edwards, a strategist at investment bank Société Générale.

Edwards looks at the profits of the whole economy, not just the S&P 500. The number is deducted from the GDP figures presented by the Bureau of Economic Analysis (BEA) and often leads business investment, the swing factor for total GDP.

"When whole economy profits begin to fall sharply, this is usually followed shortly after by the overall economy tipping over into recession, driven by the volatile business investment cycle," writes Edwards.

Wall Street still expects first quarter GDP to grow by a little less than 2 percent. But according to a more up-to-date indicator, this may be wishful thinking.

The Atlanta Federal Reserve Bank uses a model which takes current economic releases into account and has a pretty good track record. This GDPNow model says first quarter GDP will grow at around 0.1 percent. The BEA releases its first estimate of GDP on April 28.

(Atlanta Fed)

Only a month ago, the model also predicted growth of 2 percent, but has since moved down because of steadily deteriorating economic data. For example, after the Census Bureau reported the wholesale trade report on April 8, which was worse than expected, the model corrected contribution from inventories to -0.7 percentage points from -0.4 percentage points.

But even if first quarter GDP comes in negative, this would not technically constitute a recession. A recession is defined as two quarters of falling economic activity.

According to Bank of America, this is not a great concern though as both the first quarter of 2014 and 2015 were weak, only to be followed by a strong second quarter.

"In both 2014 and 2015, we faced the weak first quarter data and argued that the recovery remained on track. Today, we see four reasons to reiterate that call," writes strategist Ethan Harris.

After dropping 0.9 percent in the first quarter of 2014, GDP bounced back to 4.6 percent in the second quarter. It slipped 0.6 percent in the first quarter of 2015 and bounced back to 3.9 percent.

Albert Edwards thinks his approach is too simplistic and points to the bad track record Wall Street economists have in predicting recessions and stock market tops.

"They do not place enough importance on the role of profits as a driver of the economic cycle," he writes. And profits, unlike in early 2014 and early 2015, have been falling for more than a year now.